By The Valuentum Team
Xilinx (NASDAQ:XLNX) is expecting continued expansion in the markets it serves thanks to 'multi-market high growth megatrends' including cloud computing, embedded vision, industrial Internet of Things, and 5G wireless. These dynamics add to the dividend growth potential embedded in the firm's capital-light business model, which drives solid free cash flow and helps maintain a healthy balance sheet. As of the end of fiscal 2016, the company had a net cash position of nearly $1.8 billion, inclusive of current debt. Free cash flow generation has averaged nearly $740 million over the past three fiscal years (2014-2016) and has been more than enough in covering annual cash dividend obligations of just under $300 million over the same time period.
Thanks to such strong free cash flow generation, Xilinx appears to have very little dragging on its dividend growth potential. Management has been very shareholder friendly as of late, having returned more than 100% of operating cash flow to shareholders via dividends and share repurchases over the past ten years. Competing capital allocation options in the form of share repurchases (averaged more than $445 million from fiscal 2014-2016) have the potential to impact the pace of dividend expansion moving forward, and the board recently authorized an additional $1 billion in buybacks. Nevertheless, we expect the supporting macro trends to continue to fuel demand for Xilinx, and its solid free cash flow generation and impressive financial health should drive ongoing dividend increases. Based on its Dividend Cushion ratio of 2.9, we think the firm has significant room for healthy growth in the quarterly payout.
Xilinx's Investment Considerations
• Xilinx makes FPGAs, SoCs and 3D ICs. These devices are coupled with a next-generation design environment and IP to serve a broad range of customer needs, from programmable logic to programmable systems integration. The company was founded in 1984 and is headquartered in California.
• As with rival Altera, which was recently acquired by Intel (NASDAQ:INTC), Xilinx's strategy centers on the displacement of ASICs and ASSPs in the development of next-generation electronic systems. The company strives to drive down cost and power consumption at each manufacturing process node.
• Investors in technology pay close attention to a firm's gross margin to get a read for product pricing pressures. We like the company's focus on growing earnings and its extremely cash-rich balance sheet. The firm's shares have benefited from recent reports that it could be acquired for $15 billion. Potential suitors include Qualcomm (NASDAQ:QCOM) and Broadcom (NASDAQ:AVGO).
• The company is experiencing solid momentum in the 28nm market. Xilinx's quarterly revenue run-rate is expanding, and the firm ended fiscal 2016 with record levels of 28nm revenue. Difficult broadcasting and communications end markets may cap firm-wide sales growth, however.
• The company is heavily dependent on distributor Avnet (NYSE:AVT) for the majority of sales revenue and order fulfillment. Resale of product through Avnet accounts for 40%+ of worldwide revenue and for two thirds of total net accounts receivable.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Xilinx's 3-year historical return on invested capital (without goodwill) is 135.2%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Xilinx's free cash flow margin has averaged about 31.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Xilinx, cash flow from operations decreased about 9% from levels registered two years ago, while capital expenditures fell about 24% over the same time period.
We think Xilinx is worth $44 per share with a fair value range of $35-$53.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 5.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 0.7%.
Our model reflects a 5-year projected average operating margin of 29.5%, which is below Xilinx's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.2% for the next 15 years and 3% in perpetuity. For Xilinx, we use a 10.2% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $44 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Xilinx. We think the firm is attractive below $35 per share (the green line), but quite expensive above $53 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Xilinx's fair value at this point in time to be about $44 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Xilinx's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $55 per share in Year 3 represents our existing fair value per share of $44 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.